The stock market is not the economy
The stock market is not the economy
The last few months I’ve spoken to many folks that were understandably concerned about the looming economic crisis caused by the coronavirus pandemic. As the poor economic data has poured in, and the message amplified by the constant media headlines, the situation has looked ever grimmer. GDP forecasts in the USA for quarter two are now nearing -40%, with unemployment rates at 14.7%, the worst since the great depression. To complicate matters even more, the negative economic data is present across all major economies in the world.
In mid-March, it was impossible to find any good news about the economy or the stock market, and unfortunately many investors panicked, sold their investments, held cash, or even worse got suckered into high-fee annuities. But paradoxically, even among all this terrible economic data, the stock market has undergone a major recovery, and is only 7 or 8% off its early March highs. How is this possible? Why has the market recovered even while the economy has grown worse? The answer is that the stock market is not the economy. Of course, they are related, but below I’d like to discuss a few reasons why this is possible. First, a warning. I am NOT saying that the stock market won’t fall again, or that this recovery is permanent. Temporary rallies are common in poor markets (“bear market rallies”), and it’s impossible to know if the U.S. stock market is in a bear market rally until we’re looking backwards from the future.
Reason #1: All sectors have not performed equally during the pandemic
During the March panic, it was easy to view the entire market as moving downward in one giant cascade of lost money. However, while its true there was liquidity problems in the bond market, and nearly every single asset lost value over a short period of time, there was some differences. Major sectors of the U.S. economy were devastated: oil and energy, travel, financials, tourism, hospitality, and brick and mortar retail. Other sectors did substantially better, notably information technology, communication services, and healthcare. To put this into perspective, as of May 27th, the energy sector is down 33.49% year-to-date. The information technology sector is up 32.60% over the same period!
Here is the important point. The sectors that have performed well represent a much larger part of the overall U.S. stock market. As of April 30, 2020, the breakdown of sectors in the S&P 500 was as follows:
Information technology: 25.7%
Health care: 15.4%
Communications: 10.8%
Financials: 10.6%
Consumer discretionary: 10.5%
Industrials: 7.9%
Consumer staples: 7.4%
Utilities: 3.3%
Energy: 3%
Real estate: 2.9%
Materials: 2.5%
Sectors that have been hardest hit by the coronavirus economic disaster are those that represent the smallest percentage of the S&P 500, while those best positioned to weather the storm represent the greatest percentage of the S&P 500. This fact alone describes why we’ve had such a quick recovery, and why Arrow has focused its portfolios on the S&P 500 and large-cap technology companies during the crisis.
Reason #2: Large companies move the market
In the stock market, you’ve probably often heard of “market cap” as a descriptor of company size. Market cap is basically the number of outstanding shares of a company times their value. Large-cap companies for example have a market cap of over 10 billion dollars. Because of their large size, these larger companies dominate the movement of the stock market. Consider the ten largest companies in the world as of May 2020:
Microsoft
Apple
Amazon
Alphabet (Google)
Alibaba
Tencent
Berkshire Hathaway
Visa
Johnson and Johnson
Notice any trends? These are mostly technology, communication, and healthcare companies. Their business models alone are somewhat sheltered from the effect of the Coronavirus shutdowns. In other words, these companies can continue to do business as usual, and their movement will still dominate the overall stock market. The reality is that thousands upon thousands of small businesses could go out of business and people can lose their jobs, but the companies that influence the stock market the most are somewhat sheltered from the effects.
Reason #3: The stock market is forward looking
The stock market consists of a huge array of moving parts that are impossible to disentangle into anything meaningful on a day to day basis. Billions of dollars are moved by computer algorithms, pension fund rebalancing, 401k contributions, day-traders, retail investors at home, and banks hedging their positions. It’s only over longer periods of time that patterns tend to become meaningful. The one pattern that tends to be reliable is that the market is forward looking. That is most day-to-day news tends to get “priced-in” quickly, while price fluctuations over longer periods are forecasting what economic growth will look like. Therefore in today’s world you see the market not moving at all in response to terrible numbers about GDP or new jobless claims. The market is looking forward to 2021 and 2022 and what kind of growth is expected in the future.